This year saw a sea change in the way I invest. Umm…let me take that back. This year I finally decided to put in place an investment methodology. Something that will hopefully form the basis for the way I invest long into the future. I put some thought into it and so in case it might be useful to others, here it is. Needless to say, this is what works for me. Your context may be completely different and what works for you might be completely different (do leave a comment if you think it adds to the discussion).
Be Invested
The most important factor in getting a good return on your portfolio is to be invested. Leaving cash in a checking account just because you haven’t decided what to do with it, or because you are just too lazy to do some research to figure out where to invest it, can significantly erode your returns in a good year. This doesn’t mean that you can’t plan to have some part of your portfolio in cash, if that is what you intended for the cash. But if your year-end bonus comes in and sits in your bank account for 6 months before you even transfer it to the brokerage account or open a CD, that’s like overpaying for your flat screen TV at a retail store instead of buying it from Costco (I’ll bet that got your attention. For more on us cheap Indians search for Russell Peters on You Tube.)
Asset Allocation
How to allocate your money between different asset classes – stocks, bonds, real estate, commodities – is a serious, higher order question that must be answered first. The world changed for many of us in the second half of 2008. The stock market, we learnt, can be a very fickle asset class. But it is also true that many major asset classes turned out to be terribly correlated. Even so, think hard about your goals in managing your money and then decide on the right asset allocation. I have 40% of my portfolio into fixed income. Investing in bonds has become a lot simpler via ETFs and so there’s no excuse to not following a prudent asset allocation strategy.
ETFs vs mutual funds vs individual stocks
You are deceiving yourself if you think you can pick stocks to beat the index. The boasts that you and your friends make over lunch on how much money they made on Apple or Google will generally miss the important detail that you made a 200% gain on one stock which was less than 5% of your portfolio. The lunch table chatter will never be about how much money you lost on that dog that you invested in last year because you didn’t think it could go any lower. Face reality, you aren’t a stock picker. You’re just giving in to that gambling streak in you. Don’t bet your family’s future on the casino. If you must bet on individual stocks, set aside some play money to indulge yourself.
Investing in mutual funds is better but it is still a mug’s game. Do you know anybody who can beat the market consistently? I have spent a lot of time with smart money managers and I can’t say that I have. Not because the people I met weren’t smart. It’s just that beating the index consistently is just too, too difficult. Especially, net of fees. Read this if you need some convincing.
The reason I love ETFs is because they give me diversification with very low fees. And with the proliferation of ETFs, you have a vast array of investment options – stocks, bonds, commodities, different markets, even leveraged bets and shorting the index. Passively managed index funds are similar in nature though they don’t have as wide a variety.
For asset classes other than stocks, ETFs are even more compelling. ETFs are traded on a stock exchange. They are very liquid and you know what they are worth at all times. Owning bonds or commodities used to be much more involved in the past. ETFs make dead simple. ETFs also allow you to easily allocate a part of your portfolio to international markets. Owning individual international stocks or bonds is much tougher.
Emerging Markets
I have great faith in emerging markets. They will be volatile, but the long-term fundamentals are good. You can get emerging market exposure in both stocks and bonds. You can go by market or buy into all emerging markets with something like EEM. I also own EMB which is an emerging market bond ETF.
Measurement
Your broker – online or full-service is typically not going to have the tools to measure how you are doing except for the simplest of situations. I have never quite understood why. The computation and the tools required are pretty trivial. Is there like a platinum level of membership with Schwab where these tools get unlocked?
In the meanwhile, I pull down the data and compute my own XIRR. I always choose to reinvest dividends, which helps keep the computation simpler. It can get a little messy if you accumulate over time and then sell over time. But since you are doing this for yourself all you need to know if your investment is meeting the criteria you set for it or not.
Discipline
I can’t say that I have a long track record of disciplined investing. But in just this year, there has been enough temptation to break my asset allocation rules. The US markets kept climbing and here I was stuck with a self-imposed 40% allocation to bonds. But I held fast and I plan to stick it out in the future as well. Changing your asset allocation in response to an attractive investment option is exactly the kind of thing that gets you in trouble. You don’t have the dampeners in place when an asset bubble bursts.
That doesn’t mean you can’t change your asset allocation or investment strategies. But it should be done as a long-term shift in strategy rather than to spike returns in the short-term.
Next year it’s going to be tough to make a decent return in almost anything. It’ll be a good test for my new investment methodology.
In the meanwhile, I hope you find this useful. Again, I don’t mean for this to be investment advice. What will work for you depends entirely on your context.
6 am pacific 
typical high rated K-shop document 🙂
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Basab.
The idea that you are getting at via fixed asset allocation is risk-adjusted return : eg. classically, bonds are considered "less risky" than stocks, usually providing less return with less than perfect correlation to stocks, hence makes sense to make it part of the asset allocation.
However, such relationships break down often — eg. japanese bonds yielding less than 0.5% are perhaps a more dangerous asset class than Japanese real estate.
So, I'd rather not emphasize fixed asset allocation. Rather, fix a risk-adjusted return expectation. Rebalance portofolio every so often to maintain this. Unfortunately, this method requires "human juice" in terms of return/risk expectations for each asset class, so is not very practical. Yet, I think it useful to consider the argument.
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Radha – you have a good point and I should emphasize a couple of things here:
1. Asset allocation is not just about bonds. It essentially means dividing the portfolio into parts which are invested in different asset classes with a mix of risk-return characteristics and that are hopefully not all completely positively correlated. Bonds themselves can vary considerably in risk-return characteristics from US Treasurys to International junk bonds.
2. Make a strategy (which includes your asset allocation but it should be more than that) and stick to it. If you change it or fine tune it as you are suggesting, do it for a higher level strategic reason. Not because you got a good tip from a colleague and thought that was good enough to liquidate your CD and invest it in a hot tech stock.
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On that lunch room chatter that voices only the upside and never the downside. I use this test.
I ask those smarts what they did with the "liquidity" provided by their remarkable exits. They usually say they parked it in some other stock they think will move north and a few weeks down the line the bubble bursts and they end up with egg on their faces… Meanwhile the stock they exited would have still moved up by a neat 10-20% up…!!!!
I'd say exit is a no-brainer if you are a long-only type investor. It's the redeployment of liquidity that reveals your genius.
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You are right. For actively traded portfolios with individual equities for every successful investment there are two decisions that you need to get right. When to buy and when to sell. Which is why it is near impossible for lay investors or even professional investors to consistently beat the index.
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My experience is that professional investors / fund managers perform worse than an individual investor over a period of time. The reason being (a) he deals with other peoples' money (OPM) and his mistake would mean at best loss of some commission or at the most his job (b) he has compulsions to sell at the wrong time because of periodic redemption pressures (c) brokerages offer kickbacks each time he churns the portfolio – so he has a vested interest in frequent churning and will not wait for absolute returns to capture the maximum upside.
Still for all that goof-up, the poor individual investor has to pay him annual (mis)management fees 🙂 In case if the individual directly engages himself, he will not churn the portfolio as much and would wait till the market gets back in its upward momentum. His risk at best is limited to blocking of capital in the short to medium term and not erosion of capital to the extent he pays management fees for a manager that in fact leads him up the garden path attributing to his so-called `expertise', that is often nothing but pureplay randomness disguised as consummate skill.
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I tend to agree with your opinion on professional money managers. But I would still say that investing in individual equities is dangerous. A diversified basket of equities through cheap index funds or ETFs is the way to go.
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Basab,
Wishing you a happy new year…
1) This is a question for indians who will return to USA in the short term (May be many people like myself who have this question… ) – For my 401K i have invested in pimco Stable value fund… This fund gave 5 % annual return for the past 10 years (including 2009)… As of now it has beaten the stocks funds available in 401K over 10 year time period. Are there such funds available for non 401k which are also liquid?
Reason for this question is long term i am not going to settle in USA and i will go back to India… The exchange rates are not favourable now… I am sure if i wait the exchange rate will go above 50 (Rs/ $) considering the fact real inflation is 20 % in india and when the fed starts increasing the rates the $ must appreciate…. The swings in exchange rates are very high (39 to 52)…
2) My 2 cents on the stock investment and new year resolution (I read it only in June'2009 and missed 2009 sales on indian stocks but still is useful as i may have another 30 + years of investing ahead of me ) – http://www.sanjaybakshi.net/Sanjay_Bakshi/Article…
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Sorry Sankar. I am pretty far from being able to answer your question on funds or indeed to comment on the movement in the exchange rates. I too have an interest in the India-US leg and would love to be able to figure out the answer to the exchange rate question!
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I love the blog of Sanjay for investing (http://www.sanjaybakshi.net/Sanjay_Bakshi/Welcome… Do you know if IIMA professors do similar blogs on value investing ? If so can you please give me the links?
3) Back to stocks if you have liquidity to take care of the family you need to worry only about 1 decision… Buying on sale like thanksgiving purchases .. If we buy at major crashes we will always make money…
Thanks
Sankar
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Basab – what you said makes sense. I'll add a couple of points here. I think it makes a lot of sense to get a "unified" view of your assets and liabilities across the board. If you are an HNW individual, your private bank might give this to you. But now you have a variety of personal finance websites that do this for free. I am on mint and I love it. It really helps you track spending patterns and make course corrections. Looking at checking, savings, CDs, credit card, 401k, loans and all in one place and then viewing your income and spending by categories (with configurability thrown in) is a boon.
The other point is to maximize whatever your company offers by way of 401k matches or equivalent. I know too many people (myself, at one point, included) that let this "free" money go by.
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Bharat – I use mint.com too and love it. But it does much better with expenses management and as you have said giving a complete picture of assets and liabilities in one place. But it doesn't do as well with portfolio performance.
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I broadly agree with rules laid down by you. However, I think timing does matter and short to medium term shifts in asset allocation should be okay to take advantage of market troughs. One way of achieving that could be to link asset allocation to market multiples, i.e. allocate more to equities as market P/Es get lower during bear phase and reduce allocation to equities as markets become expensive during bull phase.
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I have made 1.5 crores in Indian stocks and real estate in past 7 year span .
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Basab,
I spent a good part of my vacation tuning my 401(k) portfolio and found your post to be timely in that sense. Here are some of my own thoughts in a nutshell on this topic:
a) To your point about staying invested, an auto-pilot plan is the best creation for most people. I was pleasantly surprised to find a modest sum in my 401(k) ( you can tell that I am not the kinda guy who looks at his account every morning), when I was doing my year-end review.
b) Investing goal and time horizon are important. The goal part if a bit psychological — it feels good to see that you have move in a positive direction towards a goal and that keeps you going. Horizon is of course important to determine the asset allocation. Divide your goals into short, mid, and long-term goals and pick the "right" ( I put that in quotes because I think nothing is that certain) baskets to invest.
c) As you pointed out, play with stocks strictly with your play money. Unfortunately, I think most people come to this conclusion the hard-way. Some make it big initially and go for it, and some just recoil after a few missteps. I still think there is value in picking individual stocks and taking on some risks, provided you don't sink your entire savings into it. No risk, no reward. Stick to < 10 companies at any given time so that you can keep tabs on the companies and stocks. Investing in your company's stock may be good because you understand what is going on on a day-to-day basis. Just my experience.
d) Active vs Index: I read quite a bit on this topic over the break. I understand that asset allocation plays a more significant role than individual fund picking — no fund manager could have saved me in 08 if I had 100% in stocks. I am thinking of a hybrid approach — active for my 401(k) and index for my non-IRA accounts — and here is why: There are two camps; why believe either of them completely :). Seriously, I find most of the index vs actively managed argument to be a bit generalized. Index funds beat more than 80% (don't quote me on this number) of actively managed funds; For most average (am I average, above, below? ) investors index funds are the best choice etc. To confuse matters even worse, even in index funds, there are plenty of them, and not all of them follow the same indexing strategy.
Yes, there are a lot of crappy funds out there with ridiculous expense ratios, but I still feel that there are good fund managers with good long-term track records that run funds with reasonable expense ratios. There are some good resources such as Morningstar, Kiplinger's etc. that analyze funds and managers. Hey, if they can deliver me better results, why not atleast allocate part of my portfolio with them? And frankly, if I end up with 100k less in my retirement account because of this decision, I don't think I will kill myself :). So I decided not to trust any one fully and decided to go the active way for 401(k), where the tax effect of turnover doesn't matter and index for my non-IRA, where taxes have a big impact.
e) The benchmarking metric is another confusing thing: a nice plot of a hypothetical $10000 that someone invested 10yrs back. That is not how I invest. I dollar-cost average and my returns have no correlation to those graphs. Morningstar has come up with another metric called "Investor returns", which I am yet to follow-up on and understand. I have often wondered why there isn't a model that says if you DCA twice every month, here is how you would've ended. I realize that it is not a generic model, but it is still something close to what most investors do/are advised to do.
This is where I stand with my investing wisdom. I am sure I will mature as I learn more in the years to come. I will reflect on this post someday and think about how immature I was, like I do in other walks of life.
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